2012 A Level H2 Econs Paper 2 Question 4

4.         Governments generally face trade-offs between different macroeconomic policy objectives. Discuss how far a government’s macroeconomic policy decisions when faced with these trade-offs are affected by the extent to which the economy is open.                                                                                                               [25]

 

Introduction

As far as possible, governments will usually seek to achieve key macroeconomic objectives including sustained economic growth, Low inflation, Low unemployment, healthy balance of payments. 

Macroeconomic policies conventionally used to achieve these objectives include monetary, fiscal, supply side & trade policies.

Trade offs between Macroeconomic Policy objectives

1.     Economic growth / unemployment conflict with inflation

-       The use of expansionary demand management policies is usually used to stimulate economic growth during times of economic recession or stagnation.

-       In the case of expansionary fiscal policy, an increase in government expenditure (G) or an increase in Consumption (C) and Investments (I) from a cut in personal income taxes and corporate income taxes will result in an increase in Aggregate Demand (AD)

-       As AD increases —> real national income increases, bringing about an increase in economic growth.

-       As firms increasing hiring of factor inputs such as labour to increase level of output will result in a fall in unemployment

-       If the economy is already operating at full or near full employment level, this brings about an increase in general prices level —> bringing about demand pull inflation

-       Thus, Macroeconomic policies to achieve an increase in economic growth, will also bring about an increase in inflation

2.     Economic growth / unemployment conflict with balance of payments

-       As real national income increases, consumers see an increase in disposable income —> increase in purchasing power —> this increases their ability to buy goods and services —> this includes the buying of imported goods —> worsening of current account —> worsening of balance of payments

How such macroeconomic policy decisions when faced with these trade-offs are affected by the extent of how open the economy is

1.     The use of interest rates vs exchange rates

-Expansionary monetary policy can sometimes be considered to mitigate the impacts of a rise in unemployment or fall in economic growth

-Contractionary monetary policy can also be considered to mitigate the impacts of significant increase in inflation

-The use of interest rates, however as a policy instrument is sometimes limited by how open the economy is

-In the case of a small and open economy, the increase and decrease of interest rates will cause significant inflows and outflow of hot money / short term capital flow

-This can lead to significant appreciation and depreciation of the exchange rate, leading to significant fluctuations of the currency which can be undesirable as there can be consequences towards imported inflation and changes in exports competitiveness

-Moreover inflation in an open economy is more likely to be caused by external factors (which exchange rate policy may be better able to mitigate) compared to domestic factors such as domestic consumption driven demand pull inflation.

-Thus, the choice of whether to use interest rates or exchange rates as a policy instrument to stimulate the economy / control inflation depends on the extent of the openness of the economy

 

2.     Appreciation stance vs depreciation stance of exchange rate policy

-A devaluation of the exchange rate is sometimes considered to increase export competitiveness of an economy

-A depreciation of the currency can however also bring about imported inflation as imported goods become more expensive for locals to buy when the currency becomes weaker

-In small and open economies like Singapore, the use of imported raw materials and semi-finished products is extensively used for production of exported goods and services

-This means a depreciation of the currency to boost export competitiveness can be immediately negated by an increase in cost of product for exports

-A ‘modest and gradual appreciation’ stance of the SGD is adopted in Singapore because it is considered that while a devaluation would unlikely be beneficial for improving export competitiveness, a slow appreciation of the currency can mitigate inflation to some extent and also boosts investors confidence in the economy.

 

3.     Protectionism

-In light of persistent balance of payments deficits caused by persistent current account deficits, governments may sometimes consider the use of protectionist measures such as tariffs to reduce import expenditure

-Through a reduction of import expenditure à this can reduce current account deficits à improving balance of payments

-However, tariffs can lead to imported goods becoming more expensive à cost-push inflation can happen as a result of protectionist measures being imposed

-If a country is extremely open with trade taking up a large % of GDP, protectionist measures can be harmful as there is a possibility of

a.         Retaliation where similar protectionist measures are imposed back on the country’s exports

b.         Fall in export competitiveness - The tariffs if imposed on imported raw materials and inputs, it may result in an increase in the cost of producing exports

 

In this case we can see that the consideration of the use of protectionist measures can be dependent on how open the economy is.

 

How such macroeconomic policy decisions when faced with these trade-offs are not affected by the extent of how open the economy is 

Macroeconomic policy decisions are subject to the consideration of many factors and not simply dependent on how open the economy is.

Other factors include

1.     Whether the trade-offs can be mitigated or accepted if no mitigation is possible

-Expansionary demand management policies can cause demand pull inflation if the economy is operating at full or near full employment level

-This can be mitigated by the concurrent use of supply side policies to increase productive capacity of the economy through an increase in LRAS

-In the case of macroeconomic policies where mitigation is not possible, then, the decision may be to decide whether the achievement of one goal, while resulting in trade-offs is acceptable based on the consideration of how ‘costly’ the trade-off can be.

2.     Size of the economy

-The size of the economy can have implications on matters like multiplier value as this will limit the effectiveness of macroeconomic policies.

-For example, in countries like Singapore, expansionary demand management policies is not as effective due to the small multiplier size, which is why Singapore adopts the use of exchange rate policy as well as a prudent fiscal policy to achieve long-term economic growth and price stability as compared to large economies like U.S. & China.

-Thus, apart from just the openness of the economy, the size of the economy, matters as well

 

Conclusion

1.     Macroeconomic policy decisions are heavily affected by the extent of how open the economy is, but is not the only important factor

2.     Other factors include the size of the economy

 

Essay, 2012EUGENE TOH